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The Matter of Deficits, Sovereign Default, and Modern Monetary Theory

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August 18, 2010 – Comments (38)

Okay, fair warning. This is going to be one of my "thinking (and probably unfortunately rambling) out loud" posts. But I really do hope you read it because I am looking for feedback in this post. Because some of the conclusions I come to are ..... disturbing.

Let me also preempt the reading of this post and any subsequent discussions that I am not advocating for *anything* in this post. I am simply exploring what the world would look like if I were looking through Modern Monetary Theory's eyes.

The reason for this post:

I am very concerned about sovereign debt risks and the possibility of sovereign defaults. From a traditionalist standpoint, the US is running massive budget deficits, and issuing bonds at an alarming rate to try to keep the stimulus going but also just to simply keep the government running. Tax revenues are falling. This also seems incredibly unhealthy and unsustainable.

So from this point of view, the default risk of United States sovereign debt is certainly not zero. There are arguments regarding the size of the risk (based 90% debt-to-GDP, 100% debt-to-GDP, etc.). There are a whole host of ways to look at sovereign risk in historical terms.

Now there is another point of view, the Modern Monetary Theory view, regarding the sovereign default risk of the US

.... and it is 0. Not 0.0001%, not 0.00000000000000001%, but precisely and identically zero.

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I have been doing a lot of reading, thinking and pondering on this topic. I want to take you all along for my thought experiment ride. And I want to solicit feedback regarding the validity of my analysis. Again, I am not looking for ideas on whether the current framework is 'good or bad' (even though inevitably some of my own thoughts on the matter are likely to show through). I am trying to simply understand it. Understanding is, after all, the key to risk evaluation.

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So the idea goes like this

The United States Government (which I will just abbreviate as USG from now on) is sovereign issuer of its own currency. The Fed (as an arm of the government) can expand its account instantaneously, what we refer to as 'money printing' (although all of us are aware that this is an electronic transaction and not a physical one. They are not actually running the printing presses when they do this. But the metaphor is apt). Since the Federal Reserve is the monopoly issuer of the Federal Reserve Note (FRN from now on), which is of course the current incarnation of the US Dollar, and the FRN is non-convertible (it is quite literally 'fiat') there is no constraint on the number of FRNs in existence.

What this means is that the US Government is never revenue constrained.

Why?

Because notice in our definition of the FRN the Fed does not have to look at tax receipts or the size of the national deficit or the success of bond auctions with China and Japan as buyers. It quite literally says 'I have a million/billion/trillion/etc. FRNs in my account today' and can subsequently fund the government with whatever it needs instantaneously.

Now I expect a lot of people are yelling at me right now and saying "it's not that simple!". Which is technically true. But the reason, which I will show in a second, is because of a hold-over from earlier monetary times. There is literally nothing that would stop funding of the USG in this manner in practical terms. But even the the term 'funding' requires clarification in the MMT framework which I will get to in a minute.

First, let me address the "it's not that simple!" criticism with a simple question:

What is a US Government Bond?

From here: A bond is a debt investment in which an investor loans a certain amount of money, for a certain amount of time, with a certain interest rate, to a company. A government bond is a bond issued by a national government denominated in the country's own currency. Bonds issued by national governments in foreign currencies are normally referred to as sovereign bonds. The first ever government bond was issued by the English government in 1693 to raise money to fund a war against France. It was in the form of a tontine.
 
This definition makes sense. It is what we are all used to. And let me illustrate why: The British Pound Sterling, or the US Dollar (not FRN, remember the Federal Reserve is a recent invention historically speaking) used to be convertible currencies. That is you could 'convert' the currency for a specified amount of gold or silver. In the past, governments were most definitely revenue constrained. There was a fixed amount of gold and silver in the world (new mining supply adds to the above ground supply historically by 0.25-1.5%, very small and largely insignificant).

So in this case, how does a government run a deficit?

You bet, it issued debt in the form of bonds. Creditor nations (ones that ran budget surpluses, based on collecting more taxes than they spent) could loan gold and silver, or their own currency (and since it was convertible was equivalent to loaning gold and silver), to debtor nations to fund projects. In the quote above, it was to fund a war.

The government bond market was basically invented as a way to get around the gold standard. Now, I am not trying to cast judgement, I am simply reviewing history to see what makes sense. Quite often a government felt an activity was so important that it felt like it needed more money than they had immediately (which generally boils down to two categories: wars or stimulus). Since the gold standard is by definition fixed, it requires all budgets to be balanced. You cannot spend more money than you have. Unless you have a alchemist in the back room turning lead into gold (which coincidently, alchemy was a *government* funded endeavor in the Middle Ages). The reason is simple. Again, I am not casting judgement, just making an observation. Politicians and Bureaucrats are not accountants and economists. They don't want constraints. Balancing a budget is hard. Fiscal planning is hard. Large expenses in the short term mean cutting elsewhere to balance. Politicians like to promise, and they are quite bad (historically speaking) at taking away.

So this is where the very rich history of sovereign defaults originates. When a government takes out debt and spends it on unproductive endeavors (war being most egregious form of an unproductive endeavor) or even endeavors that are simply less productive than the rate of borrowing (i.e. the debt incurred does not increase GDP and/or tax revenues to cover the servicing cost), then the deficit becomes structural. Historically the accumulation of too much structural debt is the primary reason for sovereign defaults under previous monetary systems.

... okay, so the point of that was to show why Government Bonds came into existence in the first place. Again. I am not labeling them as 'good' or 'bad'. I am simply trying to recognize where they came from and how they fit into today's world.

Now lets fast forward to 1971. (I am skipping over a lot of important details, such as The Federal Reserve Act of 1913, the Bretton Woods Agreement, etc. Because I am focusing on sovereign debt in this post and trying to answer questions regarding default risk)

Nixon closes the gold convertibility window. This means that the FRN (not the US Dollar anymore) is 100% fiat for the first time. The reason? To pay for the Vietnam War. Now I am sure a lot of economic historians will argue with me regarding its usefulness in removing the world from the shackles of gold or other ideological statements. My point in making this statement is that the conversion in 1971 was based almost completely on practicality. The US Treasury could not honor gold and silver commitments, we were engaged in an escalating war, the traditional route of USG bond offerings were getting progressively worse (interest rates), so it was time to change the rules of the game.

And the point of this post is to realize just how much they changed. And I have been thinking about this for a long time. I have written many posts regarding macroeconomics and the US Dollar, making many of these same observations that I have made in this post. But this point is, until you follow this train of thought all they way through, you will miss a very important, blindingly simple but absolutely alien idea which I will get to later.

So, as a testament to the haphazardness of the implementation of the 100% fiat currency experiment, I will pose simply one question:

What happened to all the USG bonds?

Recall what I said at the beginning of this post:

The United States Government (which I will just abbreviate as USG from now on) is sovereign issuer of its own currency. The Fed (as an arm of the government) can expand its account instantaneously, what we refer to as 'money printing' (although all of us are way that this is an electronic transaction and not a physical one. They are not actually running the printing presses when they do this. But the metaphor is apt). Since the Federal Reserve Note (FRN from now on), which is of course the US Dollar, is monopoly issuer of the currency and the FRN is non-convertible (it is quite literally 'fiat') there is no constraint on the number of FRNs. What this means is that the US Government is never revenue constrained.

In 1971, we got rid of the gold standard and made our currency 100% fiat. In a 100% fiat system, the currency issuer is never revenue constrained. So in this system, government bonds are irrelevant.

Practically speaking it was something that the government did not want to deal with in war time. I mean countries all around the world held USG bonds. So what would have happened? Do we covert bonds to currency at prevailing rates (like I said, there is no limit to the amount of FRNs the Fed can produce, so it could have converted all the obligations with one stroke of the pen, this was before proliferation of computers :))? What happens to unpaid but implied future interest? Do we negotiate for foreign currency holdings? How should it have been handled? As you can see, it would have been an accounting nightmare. So what did they do instead? They punted.

They left a pre-fiat concept (from above: the government bond was invented as a way to get around the gold standard) in place in a newly 'minted' (sarcasm intended) fiat world, because it was too complicated to figure out how to sort it out, and go to this new currency regime, and fight a war all at the same time. Again, I am simply trying to look at this historically, not ideologically. Because what we have now is a mess, and it doesn't make sense. And I am trying to understand why it doesn't make sense.

So now I am going to fast forward to today. Again, I am going to skip over concepts like The Great Moderation (which is a huge debate, but I am not going there at the moment), and The Credit Bubble. Because I am trying to get at Sovereign Default Risk and the place of Treasury Bonds in our current monetary system.

What happens with a USG Treasury Bond today? What is it's function? purpose?

Remember again what I said at the beginning: In a 100% fiat currency system, the sovereign issuer is *never* revenue constrained. So in our new monetary system, we don't actually need to sell bonds to raise revenue. Japan nor China is our banker in this case. In China's case, they buy US Treasuries to manage the yuan exchange rate: Steve Saville: Getting Some Things Straight Regarding China

So what gives? The Fed-Treasury "dynamic duo" is one of the keys to how our modern financial system "works"... right? Let's see what's going on under the hood (from http://pragcap.com/when-will-the-bond-auctions-begin-to-fail):

So what happens when we auction bonds?  Well, the NY Fed has accounts all over the country.  The Treasury keeps very close tabs on excess reserves so as to avoid overdraft at the Fed.  So the Treasury hops on the phone with the Fed and they target some level of bond issuance necessary to soak up these reserves.  Why do they do this?  Because excess reserves drive down the overnight lending rate so if the Fed is going to maintain the Fed Funds target rate they drain the excess reserves.  Some people view this as auctioning off bonds that “fund” our spending, but in reality (because private sector net savings is public sector deficit – TO THE PENNY) it is just a monetary tool that helps the Fed hit their almighty and supposedly omnipotent target rate.

So now I need to back up for just a minute and address the The Federal Reserve Act. The idea of founding the Federal Reserve back in 1913 was to address the "booms and busts" that occurred under the gold standard. The idea being that the Federal Reserve could manage the money supply, expand and contract it somewhat around the gold standard to even out the boom/bust cycle [rant alert! I need to interject in my own thought because even though this whole idea sounds nice, neat and smart in theory, the fact of the matter is that booms and bust did *NOT* happen because of the gold standard, but because of deficit spending / bond issuance by not adhering to a gold standard. The boom/bust cycle is primarily driven by excess government indebtedness, which eventually migrates to the private sector leverage, which begets speculation. The formation of the Federal Reserve is simply the 'fix' to a misdiagnosed problem. end rant]. So they had a very specific function and mandate under a gold standard (and we can argue endlessly whether this is good or not), but they have no true mandate under a 100% fiat standard. I will finish this train of thought up in a minute.

I now have to return to the statement in bold near the top of the post: until you follow this train of thought all they way through, you will miss a very important, blindingly simple but absolutely alien idea which I will get to later.

So what is this alien idea? It is expressed here which I will sum up (http://pragcap.com/the-concept-of-vertical-and-horizontal-money-creation)

When the government “spends,” the Treasury disburses the funds by crediting bank accounts. Settlement involves transferring reserves from the Treasury’s account at the Fed to the recipient’s bank. The resulting increase in the recipient’s deposit account has no corresponding liability in the banking system. This creation is called “vertical,” or exogenous to the banking system. Since there is no corresponding liability in the banking system, this results in an increase of non-government net financial assets.

When banks create money by extending credit (loans create deposits), this occurs completely within the banking system and results in a liability for the bank (the deposit) and a corresponding asset (the loan). The customer has an asset (the deposit) and a corresponding liability (the loan). This nets to zero.

Thus vertical money created by the government affects net financial assets and horizontal money created by banks does not, although its use in the economy as productive capital can increase real assets.

The mistake that is usually made is comparing what happens in the horizontal system with what happens at the level of government accounting. At the horizontal level, debt is the basis for horizontal money creation. Therefore, it is often assumed that debt must be the basis for the creation of money by government currency issuance. This is not the case.

Reserve accounting uses the standard accounting identities, but the meaning of “liability” is not “debt.” The husband-wife analogy for Central Bank-Treasury accounting relationships is apt. Since a husband and wife are responsible for each others debts, neither can be indebted to the other. That is to say, reserve accounting is a fiction that does not represent real relationships, such as exist between a creditor and debtor in the horizontal system.

Moreover, government debt is not true debt either. At the macro level, the reserves that are transferred to banks through government disbursement are used to buy Treasury’s. That is, when a Treasury is bought, this involves a transfer of reserves from the buyer’s bank’s reserve account at the Fed to the government’s account (consolidating Central Bank and Treasury as “government”).

When the Treasury’s are sold or redeemed, the reserves that were “stored” at interest are simply switched back, creating a deposit again. It’s pretty much the same as buying and redeeming a CD. It’s just a switch from demand to time back to demand in a bank account, and a switch between reserves and securities at the government level. That is to say, the government doesn’t have to draw on revenue, borrow, or sell assets to cover its “debt,” as households and firms do. It’s just a matter of crediting and debiting accounts on the (consolidated) government books, even though it may appear that there is a financial relationship occurring between the CB and Treasury due to the accounting. However, it’s just a fiction.

Therefore, the key to understanding Modern Monetary Theory is this vertical-horizontal relationship. When one understands this, then Abba Lerner’s principles of functional finance become obvious. (1) Currency issuance through government disbursement is used to increase non-government net financial assets, and taxation withdraws net financial assets from non-government. (2) Debt issuance by the Treasury is a monetary operation for draining reserves to permit the Central Bank to hit its target rate.


Basically it means this: The only reason why we (as citizens of the US) have money is because the government spent it into existence ..... !!!?!??!??!!!!!

Is this true, does this even make any sense?

The answer is yes. Like I said, in 1971, the implementation of this system was ad hoc, basic questions about about the treatment of USG bonds were left unanswered, the role of the Fed (which is irrelevant in this system) was left in place to keep the hold-over "funding" mechanisms intact (even though as I have demonstrated above, they are not necessary. The Fed buys Treasuries to manage rates, not fund the government).

Again, I have touched on this idea in the past in my large gold and dollar posts, but never has it been so clearly and simply stated. I mean, it sounds so ridiculous when stated that way. But the government spent 100% fiat money into existence which is why we have money. This makes the statement that private sector savings is public sector debt crystal clear. It is an accounting identity.

.... okay.

So let's answer this question first, before I go on:

Can the US Government default on its debt? The answer I come up with is: No.

There is no monetary reason at all for this to ever occur. Congress may do so out of spite, everybody at the Fed may get food poisoning and not be there to buy US Treasuries during an auction. But there is no monetary reason for the US to default on its debt.

.... I have thought long and hard about this, and this is my conclusion. So before I go on, the question I have of the group is: Does this make sense?

Moreover, any country that is the sovereign issuer of their own currency has no monetary reason to ever default. This would be notably Great Britain and Japan (more on this at a later time).

However, any of the Eurozone countries could default, since they cannot issue their own currencies. The ECB controls the currency and Eurozone members cannot create as much money as they wanted to service their debt. This means Greece, Italy, Germany, etc. all non-zero sovereign default risks.

DO NOT MISINTERPRET WHAT I AM WRITING! I am *NOT* saying that this situation is 'good' or 'bad'. I am first just trying to recognize 'what is' so that I can confirm my analysis and move on from there

..... If this is leaving you a little queasy feeling, you are not alone.

Because then it really further fractures the concept of money.

Fair warning, I will probably digress a little here, but I think it will be useful.

If the USG is not revenue constrained then there are three items in existence that had reason to exist in a gold standard but have no reason to exist in a 100% fiat money system: Federal Taxes, The US Treasury and the Federal Reserve.

Federal Taxes: If the USG is not revenue constrained, then taxes serve no true economic purpose. The tax code is complicated, antiquated, and wastes so much time and energy. So if the Federal government does not need tax revenues to operate, which by my observations above then it doesn't, then it is simply an unnecessary and costly (in terms of wasted productivity) hold-over from our earlier monetary system.

The US Treasury: It's main job was to hold the nations gold and silver, and to issue and manage debt offerings. None of these are applicable in the current system.

The Federal Reserve: It was invented to add flexibility that the gold standard didn't offer. Now it has a made up / ad hoc mandate of "targeting a stable inflation rate". The market can and should determine what the price of money is (which is what interest rates are) based on supply and demand.

.... These may sound extreme. But my point is stating these observations is that WE ARE LYING TO OURSELVES!. At the government level, we keep talking about funding, taxing, spending as if we were on an earlier monetary system. But as I observe, these are ad hoc holdovers based on a quick transition to a 100% fiat monetary system. The are confusing holdovers that should be eliminated.

But here is the crux of the matter: Governments always want a free lunch.

Look at the history I laid out. The bond market was invented as a way to get around the gold standard (free lunch with the risk of sovereign default), the Federal Reserve was invented as a way to get around the gold standard and the bond market (free lunch with the risk of sovereign default and bigger speculative bubbles), and the 100% fiat currency system is just the next evolution of the free lunch mentality.

At least I posit that it was when it was implemented.

The problem is that any government has never been a good steward of the peoples money. Yes, yes, I know this is a loaded statement, but I am sure good debates will ensue. But my point is that in a 100% fiat money system, the monetary supply is so much more susceptible to manipulation and politicization. We need to think very carefully if this makes sense for us or for the world.

The gold standard or the 100% fiat money standard is neither good nor bad in and of themselves. They are simply systems. How easily those systems are 'gamed' / subverted is the more pressing question here.

There is a whole other line of though regarding 'do deficits matter', 'deflation', 'hyperinflation', the current recession, stimulus spending, etc which speaks to 'good' or 'bad' and I will not address them here (however you can be sure I will in another post :) )

However.... I can foresee a 'good' outcome out of all of this (the ideological side of binve is shining through :). And that is if a government does spend money into existence, and the citizens either spend or save depending on where we are in the business cycle, and if there is no Federal Reserve then interest rates will reflect the actual demand for money. This would be a remarkably self-regulating system. Then when the government decides it wants to go to war, etc. interest rates will eventually reflect the citizens reaction to this. And interest rates are not important for bond auctions, but rather the cost of borrowing for the citizens (while the USG is not revenue constrained the citizens definitely are). And so while governments can spend like crazy, the health of balance sheets in the private sector is always the measure of a nations economic health (which is why we call this current recession a household balance sheet recession). Productivity doesn't come from the government, it always comes from the private sector. This is precisely the problem with centrally planned economies. But I am veering off topic and that is a discussion for another post.

I think this *could* be a step in the right direction towards more transparent Free Market Capitalism (assuming the Fed is abolished). Now I am not 100% no-government. They serve some very useful purposes such as the maintenance of environmental laws (at least the laws that are not written by corporate lobbyists. But we have crony-capitalism now, not free markets) and the funding of pure science endeavors that may not have immediate practical value but have far reaching beneficial human impacts. However, governments are very bad at economics and monetary policy and they should stop messing with both.

In a 100% fiat system, everything regarding the confidence of your system is reflected in your currency. And without the gamesmanship of 'selling bonds' when it no longer necessary, then a global economy could be more fruitful, productive, balanced and fair based on honest market driven exchange rates.

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So.... what do you think? Am I full of BS? Am I fundamentally not understanding the monetary system at play here? Do you agree / disagree?

Please discuss!!

38 Comments – Post Your Own

#1) On August 18, 2010 at 3:32 PM, whereaminow (30.26) wrote:

LOL, you've been hanging out with the Chartalists eh?  They are a completely wacko bunch. 

Good post. I'll have more later.

David in Qatar

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#2) On August 18, 2010 at 3:39 PM, binve (< 20) wrote:

whereaminow,

>>LOL, you've been hanging out with the Chartalists eh?

LOL! Not quite. But some work done by the Pragmatic Capitalist got me thinking along these lines.

>>Good post. I'll have more later.

Awesome! You are at the top of my list of people I want to discuss this with! Thanks David...

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#3) On August 18, 2010 at 4:07 PM, Melaschasm (52.15) wrote:

What this means is that the US Government is never revenue constrained.

This is where you made your mistake.  That statement is only true in a nominal sense.  Real government revenues are constrained by the amount of wealth a government can extract from the private sector.  This can come from taxes, debt, or inflation, but it is always some number less than private sector production.  For Example:

Let us pretend that America only produces bushels of apples.  We could save some bushels for the future.  We could buy stuff from other countries with our bushels of apples.  To make transactions easier, the government issues fiat currency, since bushels of apples are heavy.  If the government issues more currency, it does not change the total production of the US, it only changes the amount of currency needed to purchase a bushel of apple.

While the government can issue infinate money, with electronic cash making this easier because paper and ink is no longer needed, the purchasing power is still limited to the amount of real wealth that can be taken from the people. 

If the US were to print $100 trillion in 2011, it would not increase the number of apples produced by the US, and thus it would not change the total real wealth of the US.  However, doing so would cause a shift in wealth to occur.  People who owned and stored real apples would gain great wealth in nominal dollars, while people who sold apples and stored money would lose most of their wealth as the number of apples they could buy would be reduced.

 

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#4) On August 18, 2010 at 4:10 PM, leohaas (32.65) wrote:

You are correct that the USG cannot default on its debt (unless Congress wants it--be prepared that will happen if the Tea Party ever gets to power). The USG can always print more money (you call it "spend it into existence", but that is the same). I have argued that several times in response to blogs here on CAPS. Indeed, taking it to extremes would be to abolish all taxes, and just have a government that prints and prints and prints. More and more dollars will chase limited resources, and the result will be hyperinflation. Many here on CAPS have already argued that we are heading that way...

You are also correct that eurozone countries can default. Eurozone countries are to the euro like US States to the dollar. Nothing new under the sun here either, right?

You argue that we can eliminate the FED. Libertarians have said so over and over again (actually, they say the FED MUST be abolished), so that is not too far-fetched either.

What is new (at least to me) is that we could abolish the  US Treasury. That is something I'd have to think about. At this point, I do not see any flaws in your argument.

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#5) On August 18, 2010 at 4:21 PM, Melaschasm (52.15) wrote:

[edit] when I said 'private sector' I meant from its people. 

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#6) On August 18, 2010 at 4:29 PM, GNUBEE (25.06) wrote:

Thanks E,

First off, I like the fact that income taxes are an antiquated and unecessary cost :)

Second, I think that the thought string you have laid out above is how people need to be thinking. "What is the modern system, how do it's components actually function and can it work together in a system?" are all excellent areas to look at. I am glad to see others are examining the system rather than keeping an outdated view of the mechanics.

 I agree with your reasoning, but moving to a pure fiat currency may rely too heavily on perception. As long as people buy into the system, it works. Once people do not trust the system it will cease to function. As long as USD USG strength and security are maintained in the worlds eyes the system can continue. It is evident that the majority still see the US system through old world glasses based on popular views. Problem is is the world ready to accept a "gamesmanship free" system?

All though I do enjoy those with outdated reasonings of outcomes, like my favorite one where China sends over some thugs with leather jackets and baseball bats replete with pinkly rings asking us to "pay up"

Keep up the good work

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#7) On August 18, 2010 at 4:42 PM, binve (< 20) wrote:

Melaschasm ,

Thanks for the comment.

>>This is where you made your mistake.  That statement is only true in a nominal sense.  Real government revenues are constrained by the amount of wealth a government can extract from the private sector.  This can come from taxes, debt, or inflation, but it is always some number less than private sector production.

I am not disagreeing with you. I know what you are getting at and I agree. But you are missing the point I was trying to make. I was not going into the realm of 'fiscal stability', or 'sound monetary policy'. I am simply asking 'can the USG default on its debt?'.

Here is an example at the extremes. Any theory that works has to work in the extreme.

What if the USG offers 900 quadrillion dollars in Treasury debt, can it go into default? And the answer is 'no', because the Fed can instantenously say there are 901 quadrillion dollars in existence and service the debt.

The question of the 'value' of an FRN in this case is beyond the scope of this post (but we both know the answer).

I am simply asking, is the default risk of US soveign debt zero or non-zero. And per my logic above, it is zero.

>>

While the government can issue infinate money, with electronic cash making this easier because paper and ink is no longer needed, the purchasing power is still limited to the amount of real wealth that can be taken from the people. If the US were to print $100 trillion in 2011, it would not increase the number of apples produced by the US, and thus it would not change the total real wealth of the US.  However, doing so would cause a shift in wealth to occur.  People who owned and stored real apples would gain great wealth in nominal dollars, while people who sold apples and stored money would lose most of their wealth as the number of apples they could buy would be reduced.

Completely agreed with these staments, but like I said, they are beyond the scope of this post. However I will probably write another post that talks specifically about what you are discussing and I would love to follow along this train of thought then. Thanks!

leohaas

Thanks for the comment leo

>>You are correct that the USG cannot default on its debt (unless Congress wants it--be prepared that will happen if the Tea Party ever gets to power). The USG can always print more money (you call it "spend it into existence", but that is the same). I have argued that several times in response to blogs here on CAPS.

I am definitely coming to that conclusion

>>Indeed, taking it to extremes would be to abolish all taxes, and just have a government that prints and prints and prints. More and more dollars will chase limited resources, and the result will be hyperinflation. Many here on CAPS have already argued that we are heading that way...

Yeah, that is a risk, but I still maintain that the balance sheet recession we are in is extemely deflationary and the spending on stimulus is hugely inflationary. And that we will not get either monolithic inflation or deflation, but something more akin to stagflation.

>>You are also correct that eurozone countries can default. Eurozone countries are to the euro like US States to the dollar. Nothing new under the sun here either, right?

right

>>You argue that we can eliminate the FED. Libertarians have said so over and over again (actually, they say the FED MUST be abolished), so that is not too far-fetched either.

Yeah. What I am trying to do in this post is to follow the logic. If this really is how shockingly simple our monetary system is, and you understand why the Fed was invented to begin with, you realize that not only is their role uncessary, but their very presence now interferes with the proper pricing of money

>>What is new (at least to me) is that we could abolish the  US Treasury. That is something I'd have to think about. At this point, I do not see any flaws in your argument.

Cool. Please come back if you have addtional thoughts! Thanks!..

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#8) On August 18, 2010 at 4:46 PM, binve (< 20) wrote:

GNUBEE ,

Thanks man!

I appreciate that. Yeah, I really am trying to undestand and illustrate the mechanics. Because the disucssions today make assumptions that aspects of both systems (old: revenue constrained and new: non-revenue constrained) are in play.

I am not sure how I feel about the 'quality' of our monetary system, but since it is not going away, I better understand better :) We all need to.

>>All though I do enjoy those with outdated reasonings of outcomes, like my favorite one where China sends over some thugs with leather jackets and baseball bats replete with pinkly rings asking us to "pay up"

LOL! China is the sharks and we are the jets :)

Thanks man!..

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#9) On August 18, 2010 at 5:49 PM, outoffocus (23.35) wrote:

Basically it means this: The only reason why we (as citizens of the US) have money is because the government spent it into existence ..... !!!?!??!??!!!!!

Good stuff. I remember reading something along these lines before on this site but I don't remember who wrote it. I agree they should get rid of Federal taxes. They are so antiquated they are merely used as a tool to control private behavior.  If that wasn't the case, why have all these deductions, credits, and exemptions? Why not just one flat rate?

However, unless states and localities began to obtain all of their funding from the USG, state and local taxes are still relevant because states and localities are in fact revenue constrained.  This is evident by the extreme cost cutting measures going on in different states around the country.  But then again I probably prefer paying taxes to the states and municipalities than the USG because they act more like a government than the USG.  The USG acts more like an extremely large corporate conglomerate.

I think Melachasm has a good point about being limited to production.  His theory explains the inflation we've experienced over the past 100 years despite various interest rates and why we could experience futher or hyperinflation if the goverment puts their spending into overdrive.  But with the amount of deflation occuring within our system combined aliong with our continuous spending, we will, as you stated end up with some horrible combination of the 2 - stagflation. I've argued several times that we are already in the midst of stagflation.  The economists probably wont pick up on it until we hit hyper-stagflation, where the data is so back it can no longer be ignored by the made up, I'm sorry I mean "revised", economic numbers.

In other news, SLW broke $21 a share and I hit 58% accuracy today (thanks to valyoo pointing out some treasury etfs to redthumb) *pops champagne*.

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#10) On August 18, 2010 at 6:27 PM, binve (< 20) wrote:

outoffocus ,

Thanks!

>>If that wasn't the case, why have all these deductions, credits, and exemptions? Why not just one flat rate?

Exactly

>>However, unless states and localities began to obtain all of their funding from the USG, state and local taxes are still relevant because states and localities are in fact revenue constrained.

100% agree. That is precisely why I said 'Federal Taxes' and not 'Taxes'. States are revenue constrained and people are revenue constrained and corporations are too, but the USG is not.

>>I think Melachasm has a good point about being limited to production.  His theory explains the inflation we've experienced over the past 100 years despite various interest rates and why we could experience futher or hyperinflation if the goverment puts their spending into overdrive.

Totally agreed. I am completely on board with his comments, but they were not addressing the crux of my analysis. If the USG cannot default, then for example, the pricing of CDS spreads is wrong for a number of countries.

The 'credit-worthiness' of soverigns is a completely different issue. Few people are acknowledging that even if the US cannot default on its debt, there is absolutely no reason we can't suffer a credit downgrade. And since US sovereign debt is used as collateral (with AAA status) in vast amounts in the OTC market, which is by far the largest in the world, even a minor downgrade would be catastrophic.

>>But with the amount of deflation occuring within our system combined aliong with our continuous spending, we will, as you stated end up with some horrible combination of the 2 - stagflation. I've argued several times that we are already in the midst of stagflation.  The economists probably wont pick up on it until we hit hyper-stagflation, where the data is so back it can no longer be ignored by the made up, I'm sorry I mean "revised", economic numbers.

I am 100% on board with your call. I am beginning to think that there are very few things that we actually disagee on :)

>>In other news, SLW broke $21 a share and I hit 58% accuracy today (thanks to valyoo pointing out some treasury etfs to redthumb) *pops champagne*.

Amen sister! Congrats! :)..

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#11) On August 18, 2010 at 6:35 PM, whereaminow (30.26) wrote:

Binve,

This is a very long post, so I'm just going to hit on the important points to me.  They may not be important points to other people.  And for now I am going to skip over the comments and hopefully return to some of them later.  I'm not going to add anything you don't already know, or at least I doubt it.  But here goes.

Government revenue is constrained under a MMT system.  I think everyone looks at the question from a modern, money-neutral perspective.  They are wrong.  Let me explain.

The value of money derives from the goods and services it can purchase.  Even though the nominal amount that the government can spend is not constrained in any way, what it can actually purpose is most definitely constrained by economic reality.  You can't fudge reality just by issuing more super-tokens with a dead guy's picture on it.  If there isn't anything the government can purchase with its funny money, then it is most definitely constrained.

I know you understand this, but I wonder out loud right now if any proponent of MMT or Chartalism or Keynesianism or any other macro economic nonsense grasps this simple point.  You can print all the money you want, but if it doesn't buy anything, it ain't worth sh*t.  So yes, the government is revenue constrained. It's constrained by economic reality.

Worse yet, as you know, while these economic cranks engage in this fantasy of a government that can do anything it wants, the people go bankrupt.  Then they burn Washington, D.C. to the ground or they find themselves completely dependent on government subsidies, slaves to a ruling class - a ruling class, btw, that has proven itself to be completely incompetent and delusional.  Heck, they can't even win a war with a $ Trillions budget against a country with no army, navy, or air force.  You can't get more pathetic than that.

The next point that the MMT'ers can't explain is how this system of issuing currency willy-nilly from a central planner is not central planning.

The next point that the MMT'ers can't explain is how diluting the currency value of poor people, and transferring that purchasing power to the politically connected through inflation equates with social justice.

The next point that MMT'ers can't explain is why anyone would ever save any money, if the government is just going to be the sole arbiter of money's value.  If on a whim, and without my consent, the government is just going to issue more tokens (that's what they are), then why would I hold any of their tokens. Of course, I'm going to immediately exchange them into something that will hold value - be it gold, art, grand pianos... f*ck anything that can't have its value eviscerated by a central planner whenever he deems it necessary.

But to get back to your point... why does the USG issue bonds?  It appears just to keep the game running and nothing more.  It's the greater fool theory on the grandest possible scale.  Here's my take: 

Let's say you are a creditor to the USG.  The only reason you extend credit to the gov is because you know they'll do whatever takes, no matter draconian, to pay you that money back.  You hope that it still holds value - real value, not just nominal value - to purchase the things you want when you get it back.  But you are definitely getting it back.  It's only how much real value it will have.  So you keep going down this road for as long as it takes until it blows up, because A) it's easy money - you don't have to worry about doing the collecting, and B) by the time it blows up, perhaps you can pass it off to the greater fool.

Now, the minute USG stops issuing bonds (or stops collecting taxes - the real value of FRN's is derived from the power to tax), the jig is up so to speak.  It's an announcement to the world that the emperor has no clothes, i.e. the tokens have no value.  It's a con game.

So they issue bonds because they have to.  And the more the economy slips and the more the dollar is diluted, the more bonds will be issued.  

Until one day, you wake up and the government can't buy anything with its revenue - and the sleeping MMT'ers will complain that its the people's fault for not understanding how blessed they are to have such wonderful money managers in charge of the system.  Then they turn on us.

This is simply the way the world works.

Thanks for the stimulating post!

David in Qatar

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#12) On August 18, 2010 at 7:06 PM, binve (< 20) wrote:

whereaminow,

Hey David, thanks for the comments!

>>The value of money derives from the goods and services it can purchase.  Even though the nominal amount that the government can spend is not constrained in any way, what it can actually purpose is most definitely constrained by economic reality.  You can't fudge reality just by issuing more super-tokens with a dead guy's picture on it.  If there isn't anything the government can purchase with its funny money, then it is most definitely constrained.

I completely agree. This is the discussion that Melascham and I were having. He is making extemely similar points that you are. I was not going into the realm of 'fiscal stability', or 'sound monetary policy'. I am simply asking 'can the USG default on its debt?'.

Here is the example that I was using:

What if the USG offers 900 quadrillion dollars in Treasury debt, can it go into default? And the answer is 'no', because the Fed can instantenously say there are 901 quadrillion dollars in existence and service the debt.

The question of the 'value' of an FRN in this case is beyond the scope of this post (but we both know the answer).

I am simply asking, is the default risk of US soveign debt zero or non-zero. And per my logic above, it is zero.

So the point you are making, which I 100% agree with, is 'do deficits matter'. YOU BET THEY DO!

>>You can print all the money you want, but if it doesn't buy anything, it ain't worth sh*t.  So yes, the government is revenue constrained. It's constrained by economic reality.

Amen. The reality of the situation is that the government cannot act truly independently of the private sector. They *think* they can. Keynesian economists have told them over and over that they can, but they can't. 

I can think of an extreme case:

1. The Treasury buys up every single dollar of debt: home loans, car loans, student loans, loans to your bookie :), etc. and says to the populace 'go forth and spend!' .... spend with what? That value of our currency will be asymptotically zero (also close as you can get to zero without actually reaching it. However, my point being in that even this exteme example, this massive Treasury bond that that was created to cover these private sector liabilities could never go into default because the Fed can monetize it all instantly. 

So while the issue of 'solvency' of a soverign currency issuer is never in question, the 'value' of that currency is highly in question.

The question will always boil down to, which government is looking for the biggest free lunch? Those that live within their means will have positive sustainable growth because the private sector will be in balance with the public sector. And those like Japan or the US, whose policies are completely unbalanced will suffer either a deflationary depression or stagflationary depression as the private sector balance sheet tries to deleverage from the last bubble. Deflationary vs. Stagflationary vs. Hyperinflationary depressions are all functions of the 'stimulus'  (read as: hubris) that the government is willing to engage in.  i.e. how much of a free lunch have they deluded themselves they have.

>>The next point that the MMT'ers can't explain is how this system of issuing currency willy-nilly from a central planner is not central planning.

EXACTLY!!! Government can create a good environment for growth by having a hands off policy and letting the market decide what is useful, or it can set quotas regardless of demand. They don't seem to understand that productivity is measured in the private sector! That is always where the health of the economy resides.

>>But to get back to your point... why does the USG issue bonds?  It appears just to keep the game running and nothing more.  It's the greater fool theory on the grandest possible scale.  Here's my take: 

I totally agree with this and the example you provided.

I am completely on board with your comments, and I probably should have clarfied what I meant by being revenue constrained in the post. I had a lame example in the main post but my example above in this comment was much clearer.

Thanks for the comments man!!

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#13) On August 18, 2010 at 7:22 PM, whereaminow (30.26) wrote:

binve,

I am simply asking, is the default risk of US soveign debt zero or non-zero. And per my logic above, it is zero.

Well, I think you're stretching the definition of "default" to fit it to the macro wacko theory nonsense.  If you and I are holding USG bond notes and it's more useful economically to wipe our butt with those notes than hold them, then I think we would come to the conclusion that the USG has defaulted on its sovereign debt.

The macro wackos will disagree with us, but that just goes to show how absurd their theories are.

I think my point of contention is that there are two parties to a default - the debtor that defaulted and the creditor that lost his purchasing power.  In the case of USG super-tokens (FRN's), the USG and their fantasy land economists are saying "we can never default" meaning we will never suffer.... but you might. Sucks to be you.

And with that, it's only appopriate to point out that anyone buying USG bonds is exactly that... a sucker.

David in Qatar

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#14) On August 18, 2010 at 7:42 PM, russiangambit (29.42) wrote:

Hi, binv.

Great work. I've been thinking about these things myself since I read pragcap blog every day first thing in the morning, and he has been on this subject for at leat 6 months. But never worked up the stamina to write a post on CAPS on this, it requires a lot of effort.

As you point out, taxes are just a political and monetary tool. This is just one big reason why people are kept int he dark on how the system operates.

Now, to get everybody's brain completely bent out of shape  - this model that you describe pretty much a closed monetary system. But it is not entirely correct, US is the biggest player in the global trade and has been exporting inflation for 2 years now to the emerging economies since they are on the receiving end of the US monetary policy. (Somebody posted a link to Andy Xie's article on this subject earlier today, great article but needs to be married with the monetary theory binv laid out for correct results). FED has no control over the reserves at the foreign CBs, they are the product of the foreign trade

Now, when Tresury issues bonds to soak up the reserves from the system how do they account for foreign reserves and their impact on the foreign economies?

Why do you think Chinese reduced their buying of Treasuries in this light?

I am still thinking about it, I'll let you know when I have a theory -)).

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#15) On August 18, 2010 at 7:47 PM, binve (< 20) wrote:

whereaminow ,

>>Well, I think you're stretching the definition of "default" to fit it to the macro wacko theory nonsense.

No, I am using the definition in its litereal sense. The very real question which prompts this thinking is: What should CDS rates on US soverign debt be? And the answer is 0.

Now, the much more relevant question is: What should the credit rating be on USG debt. And even if the default probablity is 0, the credit worthiness should *not* be AAA.

I guess the real pont of this post was to show how arbitrary and absurd our 100% fiat monetary system is, and how little it is fundamentally understood by those in power.

>>I think my point of contention is that there are two parties to a default - the debtor that defaulted and the creditor that lost his purchasing power.  In the case of USG super-tokens (FRN's), the USG and their fantasy land economists are saying "we can never default" meaning we will never suffer.... but you might. Sucks to be you.

100% agreed!

Thanks man!..

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#16) On August 18, 2010 at 7:50 PM, guiron (22.13) wrote:

Government can create a good environment for growth by having a hands off policy and letting the market decide what is useful, or it can set quotas regardless of demand. They don't seem to understand that productivity is measured in the private sector! That is always where the health of the economy resides.

"Letting the market decide" is just another way of saying "full-steam ahead!" In other words, the market is something we invented, not something outside of ourselves. There is no entity known as "the market" which will make decisions in a vacuum. If you have a market like ours which is totally interconnected with other nations and the global economy, you no longer have the choice of doing nothing.

Tell me, where is one example of a free market according to these theories? I'd imagine it can't exist - it's a utopia, like communism, and its adherents similarly worship it as if it were an all-powerful god. They can't understand that it's people who make up these systems, and people are inexplicable, chaotic and fallable. Markets don't make themselves.

People make markets, and when markets fail to operate properly, people have to fix them, otherwise people suffer and eventually revolt. Nobody is truly suicidal enough to put their hands in their pockets and say, "Too bad you lost your jobs! You're on your own!" The gold-bugs always fall back on visions of apocalypse and how people would behave better if their currency were pegged to gold, but we know from history that is not the case. The constraints are always pushed aside when need be - it happened during the Civil War, which gave rise to the Long Depression. The last time in the Great Depression the USG basically bought up all the gold and shut down the market.

Tell me, what's to stop that from happening again? It's human nature, so we have regulations and laws to keep our nature in check. Gold is just an artificial regulator, and an imperfect one at best, and it's no more powerful than the SEC or monetarism when it comes to putting the brakes on. Letting the markets run unregulated on a gold standard is just removing all the checks on our nature, save a single one - a non-solution with zero chance of happening.

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#17) On August 18, 2010 at 8:02 PM, whereaminow (30.26) wrote:

binve,

One more point as I read this for the second time, I think this claim is wrong:

However.... I can foresee a 'good' outcome out of all of this (the ideological side of binve is shining through :). And that is if a government does spend money into existence, and the citizens either spend or save depending on where we are in the business cycle, and if there is no Federal Reserve then interest rates will reflect the actual demand for money.

That's a bit too rosy for me.  This sets up the possibility of the total destruction of economic calculation.  Capital in a market economy works in stages and the most important element in determining costs for new projects for higher order goods is the interest rate.  The interest rate must reflect a demand for money (i.e. the amount of savings or lack there of.)  If the interest rate does not reflect reality, then determining costs for new projects - large projects that need tremendous capital investments - becomes impossible. 

And we're seeing this already.  Nobody knows what their costs are going to be 5,10 years down the road.  There is no signal because the interest rates are phony baloney.  Now human action steps in, and companies figure the best way to deal with this problem is to issue bonds.  And we get tons of junk bonds going out.

But that's not good either!!!  In fact, it's terrible.  It's just more misallocated capital - money to going to inefficient economic use. 

And with this outcome, where the government spends money into the economy without the Fed there to soak up reserves, LOOK OUT!!!  Because now you are putting newly counterfeited super tokens right into a fractional reserve banking system.  This is inflation on steriods.

At least, that's how it looks to me.  Sorry if I sound nit-picky.  If you think I'm wrong, hit me right back.  I have a great deal of respect for your analysis.

David in Qatar

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#18) On August 18, 2010 at 8:03 PM, binve (< 20) wrote:

russiangambit,

Hey man, thanks!

I used to be an 'occasional' pragcap reader (much more frequent now :) ), I would go there every few weeks and find and link to great articles. But this weekend as I was writing this post: http://marketthoughtsandanalysis.blogspot.com/2... , I was doing more research on sovereign defaults, and the fact that Japan has not defaulted and has never come close never has a satisfactory explanation. And I found a few Pragcap articles that explained *exactly* why and it just really got me to thinking....

... which is where this monstrosity of a post came from :)

>>But never worked up the stamina to write a post on CAPS on this, it requires a lot of effort.

Yeah, this ended up to be much more of a marathon post than I originally intended :)

>> As you point out, taxes are just a political and monetary tool. This is just one big reason why people are kept int he dark on how the system operates.

That is another unfortunate conclusion that I am coming to.

>>Now, to get everybody's brain completely bent out of shape  - this model that you describe pretty much a closed monetary system. But it is not entirely correct, US is the biggest player in the global trade and has been exporting inflation for 2 years now to the emerging economies since they are on the receiving end of the US monetary policy.

AHHH!!!! Good point! I knew I was missing a salient connections. I dance around that issue a little bit in the last 4 paragraphs, but I like the way you are linking them.

>>Now, when Tresury issues bonds to soak up the reserves from the system how do they account for foreign reserves and their impact on the foreign economies? Why do you think Chinese reduced their buying of Treasuries in this light?

This is precisely why I was belaboring the 1971 conversion, and the fact that they punted. When we went 100% fiat, bonds should have been eliminated right then and there. Some accounting agreement to turn them into currency. But like I said, they punted. The fact that we have this ad hoc old/new system still working together means that there is still some basic flaw in the system. I still do think it is understood and this issue could present a major problem still.

>>I am still thinking about it, I'll let you know when I have a theory -)).

Please do! Thanks man!!..

..

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#19) On August 18, 2010 at 8:13 PM, binve (< 20) wrote:

guiron,

>>"Letting the market decide" is just another way of saying "full-steam ahead!"

Not exactly. The market (which is us) will decide on how many ipods we want to produce and consume, how many cars, how many homes, etc. This is not determined in a vacuum but is a function of supply and demand. It should also be a function of money, which should also be a function of supply and demand. The market can determine when it wants to borrow and when it doesn't. Think of yourself, you know when your balance sheet is stretched and when you have slack. So do I. So does every American. As a whole (tight and slack balance sheets) would determine the overall rate at various maturities and if rates were low enough people would borrow, and if rates were high enough, people would lend (or save). They would be in balance. 

Instead right now the Fed decides what the price of money is (interest rates). This is the single biggest cause of the credit bubble. Rates are not determined by supply and demand.

>>In other words, the market is something we invented, not something outside of ourselves. There is no entity known as "the market" which will make decisions in a vacuum. If you have a market like ours which is totally interconnected with other nations and the global economy, you no longer have the choice of doing nothing.

I never said nor implied otherwise...

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#20) On August 18, 2010 at 8:22 PM, binve (< 20) wrote:

whereaminow,

>>That's a bit too rosy for me.

Yeah, I was trying to find some silver lining here, but I was definitely strechching :). But like I point out in comment #19, interest rates that are market determined (not Fed determined) would be healthier and produced more sustainable productivity. Because it would be set exactly by supply and demand, not some political agenda to 'stimulate productivity'.

>> If the interest rate does not reflect reality, then determining costs for new projects - large projects that need tremendous capital investments - becomes impossible. 

That is a very good point.

>> And we get tons of junk bonds going out. But that's not good either!!!  In fact, it's terrible.  It's just more misallocated capital - money to going to inefficient economic use. 

100% agreed. And I would argue that the Fed is in the way of letting the market determine rates which is encouraging wasteful spending and/or chasing of resources.

>>And with this outcome, where the government spends money into the economy without the Fed there to soak up reserves, LOOK OUT!!!  Because now you are putting newly counterfeited super tokens right into a fractional reserve banking system.  This is inflation on steriods.

Yeah, I definitely see what you are getting at. 

The more I understand our monetary system, the more I dislike it. And I really hated it before ...

>>At least, that's how it looks to me.  Sorry if I sound nit-picky.  If you think I'm wrong, hit me right back.  I have a great deal of respect for your analysis.

Not at all!! This is *exactly* the kind of discussion I wanted to have! I went through this crazy thought experiment and I wanted to see if others saw things the way I did. And I am kind of relieved that you don't :)

I have a great respect for your analysis as well. Thanks for the comments!!

..

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#21) On August 18, 2010 at 8:24 PM, whereaminow (30.26) wrote:

guiron,

I'm going to take a few minutes and tackle your comment. 

"Letting the market decide" is just another way of saying "full-steam ahead!" In other words, the market is something we invented, not something outside of ourselves. There is no entity known as "the market" which will make decisions in a vacuum. If you have a market like ours which is totally interconnected with other nations and the global economy, you no longer have the choice of doing nothing.

I gotta be honest.  I don't know what you mean.  What is "full-steam ahead?"  Toward what?  How? 

We didn't invent the market.  It's not like there was a Thomas Edison that flew a market kite or created a market lightbulb.  It evolved naturally because people want to exchange things they have for other things they desire more.  It's just a different way to view it.  It's not a machine that you invent.  It's an ecology that evolves. 

Who said we should do nothing?   I say remove legal tender laws, which would make fractional reserve banking and the Fed obselete.  Explain to me how that's "nothing."  I think that's something.  And I think it's something a heck of a lot bigger and more something than anything being offered by the macro wackos.

Tell me, where is one example of a free market according to these theories? I'd imagine it can't exist - it's a utopia, like communism, and its adherents similarly worship it as if it were an all-powerful god. They can't understand that it's people who make up these systems, and people are inexplicable, chaotic and fallable. Markets don't make themselves.

This is not an argument.  In fact, it's a logical fallacy.  I understand that humans are the actors in an economy, which is why economics is the study of human action, not the study of statistical aggregates.

The constraints are always pushed aside when need be - it happened during the Civil War, which gave rise to the Long Depression. The last time in the Great Depression the USG basically bought up all the gold and shut down the market.

The "Long Depression" was neither Long nor a Depression.  That's a disproven theory of the 1873 crash and recovery.  The crash itself was caused by the USG abandoning the gold standard.  How does that prove your point?  I don't know.  Your point is that you hate the idea of a free market. What use that is to anyone, I have no clue.

Tell me, what's to stop that from happening again? It's human nature, so we have regulations and laws to keep our nature in check. Gold is just an artificial regulator, and an imperfect one at best, and it's no more powerful than the SEC or monetarism when it comes to putting the brakes on. Letting the markets run unregulated on a gold standard is just removing all the checks on our nature, save a single one - a non-solution with zero chance of happening.

This is the "animal spirits" argument. I'm sorry but I need something with greater explanatory power than humans get exuberant.  That's not exactly a novel insight discovered by Keynes.  The book Extraordinary Popular Delusions and the Madness of Crowds, written in the 1800's detailed mass delusions going back to the Crusades.  This is nothing new.

All we propose is that keeping interest rates artificially low increases rather than decreases this delusional behavior.  Can you convince me otherwise?

David in Qatar

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#22) On August 18, 2010 at 8:31 PM, whereaminow (30.26) wrote:

binve,

Yeah, I was trying to find some silver lining here, but I was definitely strechching :). But like I point out in comment #19, interest rates that are market determined (not Fed determined) would be healthier and produced more sustainable productivity. Because it would be set exactly by supply and demand, not some political agenda to 'stimulate productivity'.

Yes, but you are walking into a trap.  You are talking yourself into the need for a central bank.  In fact, this probably how Walter Bagehot ended up on Lombard St ;)

The fractional reserve banking system always collapses without a lender of last resort.  And so the Fed apologist is going to hop on this comment thread and say "that's why we have a central bank!" (not true, but ok)  And what is your response then?  You're stuck in a circle.

David in Qatar

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#23) On August 18, 2010 at 8:48 PM, whereaminow (30.26) wrote:

Ok binve,

Now on to what I really like about this post =D, and why I'm spending so much time on this.

As I said before, the MMT school (or Chartalists) are really lunatics, and the main reason I say that is something you really nailed in the post:  the entire monetary system is the whim - the ad hoc gamings - of an unelected group of bureaucrats and bankers.  

Not a single idea proposed and now implemented - treated not only as law, but some kind of higher economic theory - was EVER analyzed or even discussed in a serious manner with those who are supposed to represent the voice of the people.  It wasn't voted on.  It wasn't debated in universities.  It wasn't analyzed by independent economists. 

And yet, the MMT'ers sit here and tell us that this wacko system is not just theoretically sound, but works so perfectly that only an asinine barbarian relic of the gold standard age would even think to question it!

Can they be any more arrogant and preposterous?  I am supposed to believe that a group of unelected bureaucrats and bankers would patch together a system to control our money supply that benefits the nation as a whole and not them?  And then I'm supposed to believe the MMT'ers and chartalists when they tell me it's all perfectly sound theory?

Yeah, ok.

So, yeah, we are on the same page in terms of how we view this monstrosity. 

David in Qatar

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#24) On August 18, 2010 at 9:16 PM, binve (< 20) wrote:

whereaminow ,

>>Yes, but you are walking into a trap.  You are talking yourself into the need for a central bank.  In fact, this probably how Walter Bagehot ended up on Lombard St ;)

Perfect response! I do believe that puts this whole thing into perspective :)

>>The fractional reserve banking system always collapses without a lender of last resort.  And so the Fed apologist is going to hop on this comment thread and say "that's why we have a central bank!" (not true, but ok)  And what is your response then?  You're stuck in a circle.

Excellent, excellent point.

>>As I said before, the MMT school (or Chartalists) are really lunatics, and the main reason I say that is something you really nailed in the post:  the entire monetary system is the whim - the ad hoc gamings - of an unelected group of bureaucrats and bankers. 

Exactly. That is why I was going through the history lesson, trying to figure out how and why entities like the Fed came to be. I don't buy the BS line that the Fed "came into existence to add stability to the markets". No, they were invented to get around the gold standard. I think the historical context of the Vietnam war and massive deficit spending is entirely relevant to how our current monetary system came to be. I think the description of ad hoc is entirely appropriate.

>>Not a single idea proposed and now implemented - treated not only as law, but some kind of higher economic theory - was EVER analyzed or even discussed in a serious manner with those who are supposed to represent the voice of the people.  It wasn't voted on.  It wasn't debated in universities.  It wasn't analyzed by independent economists. 

Exactly. They wait until crises to make these sweeping changes. The Federal Reserve Act was in response to the panics in the mid-aughts. The fiat money implementation was in the middle of huge deficits from the Vietnam war.

>>And yet, the MMT'ers sit here and tell us that this wacko system is not just theoretically sound, but works so perfectly that only an asinine barbarian relic of the gold standard age would even think to question it!

Yes! My point is describing the current system full is to expose how arbitrary it is. And if we had politicians who looked after monetary policy respectfully, it might not be a problem. But they don't, which is why I was harping on the free lunch idea.

>>So, yeah, we are on the same page in terms of how we view this monstrosity. 

100%. I just wanted to see if I could take the MMT theory to its ulimtate incarnation (no taxes, no Fed, no Treasury) so that they only stability is based on the level-heads of politicians. I am not holding my breath that it will work out well.

Thanks man!..

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#25) On August 18, 2010 at 10:58 PM, ChrisGraley (29.97) wrote:

The US can default even if Congress doesn't want to.

Assuming that default means that we are unable to pay that is. 

If all other nations reject payments in dollars before we give birth to the 900 quadrillion dollars, we are unable to pay. 

This was a fun read and a big rec from me.

 

 

 

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#26) On August 18, 2010 at 11:02 PM, binve (< 20) wrote:

ChrisGraley,

>>If all other nations reject payments in dollars before we give birth to the 900 quadrillion dollars, we are unable to pay.

Good point!!! :)

>>This was a fun read and a big rec from me.

Thanks man!..

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#27) On August 19, 2010 at 2:42 AM, uclayoda87 (29.37) wrote:

Government appendages that no longer serve a useful purpose would not be surprising, but I suspect that without the Fed and Treasury the similarity between the FRN and Monopoly money might be too obvious for foreign US debt holders to ignore.  I found these articles in the WSJ today.  It may be time to revisit your old blog: 

Gold - China's End Game?

 

WSJ MARKETS

AUGUST 18, 2010
Beijing Opens Up On Bonds

WSJ OPINION
AUGUST 18, 2010
The Great American Bond Bubble

 Your blog also reminded me of something I wrote last year:

Conspiracy Theory or Mission Impossible

February 18, 2009

 

 

 

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#28) On August 19, 2010 at 12:03 PM, binve (< 20) wrote:

uclayoda87 ,

Hey uc! Thanks for the comment!

>>but I suspect that without the Fed and Treasury the similarity between the FRN and Monopoly money might be too obvious for foreign US debt holders to ignore.

Exactly. That was more or less my point in describing why Federal Taxes, the Fed, then Treasury are no longer necesary in our system. To show how absurdly arbitrary it is.

I had little faith in our monetary system before, so when I followed the logic out all the way to the end, so show what it really is, I have even less faith in it :( Because I have little faith in politicians managing our money supply.

>>It may be time to revisit your old blog: 

Indeed, I think you might be right

>>Your blog also reminded me of something I wrote last year:

That was a very good one!

Thanks!..

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#29) On August 19, 2010 at 2:21 PM, Melaschasm (52.15) wrote:

Can the US default on its debt?

I am going to break this down into three different questions, in the hopes of providing you with my complete answer.

1.  Can the US be forced to default on its debt (declare bankruptcy).  The answer is no, the US can not be forced to default.  The US can print as many nominal dollars as needed to repay its debt in nominal terms.

2.  Can the US choose to default on its debt?  Yes, the US could make a strategic decision to default on its debt.  Although I think it is very unlikely, we could simply declare the debt void, and no one could force us to pay what we owe. 

3.  Will the US default on its debt in real terms?  I think the US will default on its long term debt in real terms.  Short term debt might be a good investment, but I would not buy a 30 year t-bill at 4% interest, because I expect inflation to run 2-5% over the next 30 years, with a small chance of much higher inflation.  If the US were to continue printing money like they have the past few years, it is likely that the buying power of a t-bill will be less than that which was traded for the debt in the first place.

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#30) On August 19, 2010 at 2:34 PM, binve (< 20) wrote:

Melaschasm ,

Excellent comments! Let me respond

>>1.  Can the US be forced to default on its debt (declare bankruptcy).  The answer is no, the US can not be forced to default.  The US can print as many nominal dollars as needed to repay its debt in nominal terms.

I agree and that was the conclusion I came to in the post

>>2.  Can the US choose to default on its debt?  Yes, the US could make a strategic decision to default on its debt.  Although I think it is very unlikely, we could simply declare the debt void, and no one could force us to pay what we owe. 

Again, I stated the exact same thing in the post. See this passage

There is no monetary reason at all for this to ever occur. Congress may do so out of spite, everybody at the Fed may get food poisoning and not be there to buy US Treasuries during an auction. But there is no monetary reason for the US to default on its debt.

And by 'out of spite' I am meaning it is the exact same way that you stated it. It would be a strategic default, a form of protectionism / economic warefare.

>>3.  Will the US default on its debt in real terms?  I think the US will default on its long term debt in real terms.  Short term debt might be a good investment, but I would not buy a 30 year t-bill at 4% interest, because I expect inflation to run 2-5% over the next 30 years, with a small chance of much higher inflation.  If the US were to continue printing money like they have the past few years, it is likely that the buying power of a t-bill will be less than that which was traded for the debt in the first place.

I 100% agree with this statement and is in fact being addressed in the follow up post that I am currently writing.

Thanks!!..

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#31) On August 19, 2010 at 3:29 PM, GeneralDemon (< 20) wrote:

 Hi binve,

"Can the US be forced to default on its debt (declare bankruptcy).  The answer is no, the US can not be forced to default.  The US can print as many nominal dollars as needed to repay its debt in nominal terms."

What about this:

When the perception of the buyer of bonds reaches the point whereby the value of the issue is deemed worthless (even when the buyer is also the seller)  then the transactional costs exceed the value of the offering - this is, effectively, forced bankruptcy.

 

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#32) On August 19, 2010 at 3:42 PM, binve (< 20) wrote:

GeneralDemon ,

Hey GD!

>>When the perception of the buyer of bonds reaches the point whereby the value of the issue is deemed worthless (even when the buyer is also the seller)  then the transactional costs exceed the value of the offering - this is, effectively, forced bankruptcy.

Completely agreed!

But the point I was getting at was can the USG default technically / nominally. The answer is no. But if you look at the comments above between myself and David, we completely occur with your effective default analysis.

This is a topic I am covering in my next post along these line.

Thanks!..

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#33) On August 19, 2010 at 4:02 PM, GeneralDemon (< 20) wrote:

 Hi Binve

I look forward to your next post!

You may find it interesting that many people have postulated on the future endgame - one guy (sorry, I have forgotten now who it was) made a very interesting prediction - the FED will be forced to issue bonds that the US citizen cannot own!

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#34) On August 19, 2010 at 4:17 PM, binve (< 20) wrote:

GeneralDemon ,

Thanks GD!

>>You may find it interesting that many people have postulated on the future endgame - one guy (sorry, I have forgotten now who it was) made a very interesting prediction - the FED will be forced to issue bonds that the US citizen cannot own!

That is a *very* interesting idea. If you read russiangambits comment #14, this might make a lot of sense in trying to control the currency exchange rate idependently of the dommestic supply/demand... interesting ... :) 

Thanks!..

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#35) On August 23, 2010 at 8:37 AM, mardukkorn (73.51) wrote:

Taxes are what give the money value. If the USG did not demand to be paid its taxes in USD then the USD would have no value. They could print but no one would accept it as payment for their goods and services. So  taxes are necessary  for maintaing the value of the USD.

 

 

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#36) On August 23, 2010 at 10:27 AM, binve (< 20) wrote:

mardukkorn,

>>Taxes are what give the money value.

You have to be careful with this assessment. This is the traditonal way to value the currency. When the US Government was still on a gold standard or partial gold standard, and Treasury debt was used to fund the government, tax revenues are what supported the basis for valuing the debt and currency.

Today we still apply the same logic (it is the only one that makes), but the point of this post was that the basic assumptions about "funding and revenue" are not 1-to-1 applicable in a 100% fiat currency. I am not saying this is good, I am not agreeing with it. I am simply illustrating, that if you take our fiat currency system out to the end of this experiment, we  see how arbitary it is.

This means that the value of the USD is less about taxes and Treasury debt and more about faith in the Federal Reserve to preserve a stable currency. .... This does not fill me with confidence...

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#37) On August 24, 2010 at 1:29 PM, TCWeaver (99.83) wrote:

Steep and deep. great post. 1 rec.I have to say that it has never been about the money, its about power and those who wield this power will not give it up. I do agree that the US will never default because the power holders would lose their power.

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#38) On August 25, 2010 at 1:38 AM, binve (< 20) wrote:

TCWeaver ,

>>Steep and deep. great post. 1 rec

Thanks!

>>I have to say that it has never been about the money, its about power and those who wield this power will not give it up

Very much agreed...

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